Anything but oil

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As OPEC ministers meet in Angola this week, they can congratulate themselves on a brilliant piece of market management.

Quick decision-making and aggressive output cuts over the last 18 months have stabilised prices at their highest level in real terms since the early 1980s. And this despite the deepest recession since World War Two.

The cartel has had plenty of help. Cheap liquidity from central banks has helped finance inventories, while continued enthusiasm from the investment community has encouraged the market to look past weak short term fundamentals and concentrate on the possibility of renewed price increases in future.

Ministers, led by Saudi Arabia’s Ali Naimi, can claim a large share of the credit: delivering timely and reasonably effective output cuts, limiting the stock build, and giving investors a reason to remain bullish.

But the body faces bigger problems as an “anything but oil” agenda swells with developed countries pursuing green agendas and seeking to insulate themselves from volatile markets.

Fears about the availability and environmental costs of combusting refined products have forged an unlikely alliance between the national-security right and environmental left around that agenda. It prioritises the use of other fuels (gas, coal, electricity, nuclear, renewables and biofuels) and new technologies (solar, liquefaction, carbon capture and storage) in preference to oil.

CARTELS SOMETIMES WORK
OPEC has proved cartels sometimes work, holding prices above the level that would prevail in a purely competitive market and speeding adjustment to shocks. But ministers need to recognise the challenges facing the organisation over the next two years will be at least as demanding as those since the financial crisis broke.

The biggest will be proving that the cartel’s oil can provide a competitive and reliable energy source in the decades ahead.

If not, their share of the global energy market will be whittled away by conservation and substitution policies, as well as a growing share for cheaper and cleaner burning fuels such as natural gas aimed at limited carbon dioxide emissions, and perhaps even coal (assuming carbon capture and storage can be deployed on a significant scale).

In the last five years oil has proved an expensive and unreliable energy source. Prices have gyrated wildly in response to instability in the Middle East, Nigeria and Venezuela; the producing countries’ apparent inability to bring on new capacity in a timely manner; and stalemate with the international oil companies over access to reserves. All of which have been amplified by the animal spirits of investors and speculators.

Consumers have been given an enormous incentive to switch as much of their energy use as possible into other fuels to insulate themselves from oil capricious vagaries.

PREMIUM FUEL NO PROTECTION
Not everyone has a choice. Refined products from crude oil (especially gasoline and diesel) remain premium fuels. High energy density makes them extremely efficient carriers of energy and the only realistic option for many transport applications.

But even in the transport sector, surging and unpredictable prices have resulted in demand destruction, especially in the advanced industrial economies, where the full impact of rising international oil prices has been passed on to consumers.

In the United States, the biggest energy user of all, the total volume of refined petroleum products supplied to domestic customers peaked in the summer of 2007, well before the financial crisis, and has been on a downtrend for two years.

Gasoline demand weakened noticeably from mid-2007 onwards as customers cut discretionary driving and switched from sport utility vehicles in favour of smaller and more fuel-efficient cars.

Following previous episodes of demand destruction, the cartel faced steep losses in consumption and was forced to buy back demand through a prolonged period of low prices in real terms. But this time much of the demand that has been lost has probably gone forever.

The combination of fuel efficiency measures and the ethanol mandate (passed in response to concerns about high and rising oil prices) have ensured that gasoline demand and petroleum consumption has probably peaked in the United States.
A LEGISLATIVE PARIAH

Much of that “anything but oil” agenda is now being firmly embedded in legislation. It will not be particularly easy to reverse, even if real oil prices stabilize or fall in future.

Failure to agree emissions reductions in Copenhagen and the uncertain prospect of the U.S. Congress approving a cap-and-trade programme next year provide a respite. But conservation measures, including vehicle fuel economy standards and the U.S. Environmental Protection Agency’s threat to regulate tailpipe emissions of greenhouse gases, are still forging ahead.

Meanwhile the competitive and legislative playing field is being tilted in favor of cleaner, greener fuels that are more abundant in the advanced economies, such as natural gas (including shale), bitumen sands, renewables, nuclear and coal.

The advanced economies have almost unlimited energy sources (including premium liquid transport fuels from Fischer-Tropsch liquefaction) at real oil prices well under $100 per barrel. Only a periodic collapse in oil prices has prevented these technologies being exploited more fully in the past.
Oil’s decline can be tracked in the recent editions of the International Energy Agency (IEA)’s World Energy Outlook (WEO).

In WEO 2004, the IEA projected OECD energy consumption would grow to 6,953 million tonnes of oil equivalent (mtoe) a year by 2030, of which around 40 percent would come from crude, 26 percent from gas and 17 percent from coal.

By WEO 2009, projected consumption had been cut as much as 17 percent to 5,811 mtoe (owing to a combination of the 2008 recession and the rising cost of all forms of energy). Forecast oil consumption had fallen even further, down by a massive 32 percent.

Oil is now expected to provide only 32 percent of primary energy consumption in the OECD in 2030, while the share from coal is up two percentage points and the proportion from nuclear, hydro and renewables is up almost 7 points.

OIL IS FOR POOR PEOPLE

OPEC’s customer base is increasingly concentrated in emerging markets, where economic growth, rising incomes and still-growing populations are boosting demand, and an extensive system of price controls and fuel subsidies has largely insulated consumers from the pressure to be more efficient.

Emerging markets show less enthusiasm for the climate change and anything-but-oil priorities of the advanced economies. Raising living standards for the rural poor and creating jobs for the growing number of over-educated and under-employed graduates in their urban centers is a more pressing priority than the remote risk of global warming in 50 years.

But if the advanced economies become more efficient and shift to cheaper and more reliable fuels emerging markets will come under pressure to follow suit or lose their competitive advantage. Intense oil use will be a handicap in coming decades.

Already most emerging markets have liberalized their price controls somewhat and scaled back subsidies that mostly benefit the middle class rather than the poor, when the doubling of oil prices in H1 2008 made existing systems unaffordable. China is now showing strong interest in coal liquefaction, gas from Central Asia, and greener solar power to cut oil imports. Others will follow.

If there is another spike in prices, demand destruction will not be restricted to the developed world. More volatility, especially on the upside, will only strengthen the determination of policymakers to reduce oil’s share in the energy balance.

OPEC has often called for “security of demand” to help it invest, matching the consumer nations’ call for security of supply. But unless the cartel can find a way to avert future spikes, demand security will remain an illusion, as consumer countries continue weaning themselves off an expensive and out of favor fuel.

Hopefully the trend continues to stop wasting oil on frivolous crap such as fuel. Oil is not an infinite resource and people should be thinking in terms of “How do we want to use up the last of it over the next couple hundred years?” Who thinks we should even be trying to use all of it, we might wanna save some for our childrens children type of thing.

Shuttling food to be packaged halfway across the world, then shuttling it back to country of origin can only last for so long, and it is a pathetically stupid waste of oil if one actually considers how much energy is wasted to get those food calories to them.

Mr. Kemp, I think you miss a few points here. Cartels work, but in industries like oil and shipping, they exist to avert collapse, not to extract premium profits. OPEC has had to face massive overcapacity for two decades, and now it hardly has any. There is no Cartel control, other than that capacity expansion is controlled, resulting in very tight markets ahead. Prices gyrate out of control, because demand is close to inelastic in the short run, and supply even more. There are huge lead times to get new capacity. And even if it were easy, why would anybody invest in something that would put capacity out of action and bring the price down? Perhaps for once, somebody would recognise the fact that the interest of the consumer is not aligned with that of the producers (be they OPEC or private oil companies), and neither are consumer governments on the side of their own citizen consumers. Taxation is great, and OECD governments have succesfully creamed off all price increases since the late 70s, until recently. We pay at the pump equivalents of 250-300 USD/barrel, not 70.and the refining margin does NOT explain the difference. As long as consumer governments have a vested interest in this thinly veiled taxation and great scape goat to extract even more tax from its citizenry without sparking a revolution, there will be no waning off towards other solutions. Only if and when there is an alterative that could be taxed better. Have a read of the early release of the EIA’s Annual Energy Outlook 2010. the US Gov’t expects oil consumption in the US to rise continuously, despite high prices and despite a massive GDP downturn. What would it take then to get us off oil? Only bold policy action (which would effectively stimulate the economy). But that won’t happen, as the OECD spending habits are out of control, and they need the oil taxation to pay for at least part of it (in the UK, for a large part).

What a load of ignorant baloney. What “demand destruction” is this idiot talking about? Gasoline demand is virtually unchanged in the US despite a massive recession and the fatuous ethanol mandate that takes up ever increasing percentage of gasoline supply despite horrific ecologic problems and economic subsidies.

This xenophobic fool is making a cardinal mistake by focusing on developed economies and totally ignores what has been driving demand (and prices) – the developing countries (BRIIC – Brazil, Russia, India, Indonesia and China). Imagine what happens to demand as the US and other Western economies recover – supplies will tighten yet again and prices will follow.

But why did oil spike in the first instance? It’s not because we are running out of oil – far from it. The “problem” was that oil was priced too cheaply for too long. Producers had vast excess capacity and prices collapsed to $10 bbl just a decade ago. Prices were so low for so long that it offered little incentive for new production to be brought online and the industry was caught flat footed when world demand quickly accelerated (thanks to loose US monetary policy that created a massive world wide asset bubble).

The industry belatedly responded (who can blame them for being dubious after so many decades of over supply?) and we have seen large increase in investment (that take years to see results) – huge investments in high cost oilsands and deep offshore have begun with predictable results of large new supply coming online (Saudi Arabia just brought on 1.5MM bpd of light oil – something the “experts” said was impossible a few years ago).

And a few years ago we were repeatedly told by those same “experts” that no new large (1+B bbl) discoveries would be made – presumably the large discoveries offshore Asia, South America and Africa have shown otherwise.

Frankly, I am amazed that such absurd “analysis” is deemed fit to print by Reuters.

It seems to me that the oil market price veers between a lower bound and an upper bound in the same way that water swills backwards and forwards on the decks of a RoRo ferry, and with similarly destructive potential.

This volatility is of course in the interests of market makers/speculators (the same thing) – such as investment banls and hedge funds – who aim to buy and sell oil and derivatives for a transaction profit.

For producers & consumers, and investors like ETFs who aim to take on long term energy price risk, this volatility is a tax or imposition.

It is my thesis that Shell essentially invented a new ‘oil leasing’ mechanism in 2005, enabling them to deal directly with ETF investors and thereby ceasing to pay a volatility tax to middlemen. This ability to borrow money, and lease out oil in return, was soon taken up by others and expanded once interest rates went to zero and funds flooded in to alternative assets.

But what has also happened, IMHO, is what Mike Riess calls ‘modern market manipulation’ on a macro scale – of whch the tin and copper markets gave good examples.

It seems to me that one or more producers, probably at least one oil major and at least one sovereign nation, have – financed by funds via investment bank intermediation – been inflating and supporting the global oil market price via the BFOE/Brent complex. Since only $3bn to $4bn in BFOE quality oil is produced each month such ‘macro’ manipulation does not require particularly deep pockets in global terms.

It seems to me that money invested with investment banks by energy funds is what is being used – plus liberal applications of hype – to pump up the oil price to the upper bound.

The bubble burst once already and collapsed back to the lower bound, but the continuing zero interest rates have ensured that the All the King’s Men have been marched back to the Top of the Hill again.

In a market that is not totally dysfunctional – and it is possible (see below) to imagine a ‘Peer to Peer’ dis-intermediated architecture which will work – then it would be quite possible to achieve a measure of price stability. In fact, that’s how the oil market was for maybe 50 years or more.

The question then is at what level the global energy price (in fuel use) of carbon should be set, and to work back to a fair allocation of the proceeds from this price as between consumer nations, service providers, and producer nations.

To achieve this means abandoning the completely hopeless (but hugely remunerative to the usual suspects) Kyoto/Copenhagen attempt to monetise intrinsically worthless CO2 and to monetise the energy value of carbon instead. I outlined how all this might look in Rotterdam recently in the context of gas.

I have an idea that would work if you tried it. ” No Gas Wednesday” simple . Do not buy gas on Wednesdays ! ever! oil will begin to stockpile due to lack of sales no matter how much they cut back production. In the end the little man will win.

One important point that Mr. Kemp’s analysis does not mention is US oil consumption in the agriculture and food sector. While individual consumers can switch from SUVs to more efficient cars the same is not true for the ag sector. So often forgotten, food production, processing and distribution consumes 17% of US oil imports and will not soon be replaced with green energy alternatives.

Simply put, our corn / soybean based food system runs on diesel fuel to plant (including herbicides and insecticides), harvest, process and ship food to market and will not be easily replaced with green energy unless a radical change is made to producing food such as ending corn and soybeans subsidies and encouraging grass based farming that uses much less fuel, as well as local processing and distribution, something the USDA (and the big food industries) have done its best to eliminate since the early 1970s.

Americans are in for a real shock when the heavily subsidized cheap food (thanks to cheap oil) begins to reflect the real cost of production and current oil prices, let along $147 per barrel oil prices of July 2008.

While energy at the pump may be down from highs of $4.70 per gallon, the July 2008 prices have already severely impacted the agriculture sector forcing many more farmers out of business. In southwest Virginia, where my wife and I operate a grassed based dairy, the dairy industry is in trouble (due to high energy costs and very low milk prices) and while most of us don’t give it much thought, those farmers have consumed their seed money to stay in business through this winter. Due to the tight credit markets, banks are not willing to lend to farmers for this springs planting which will likely result in dairy shortages and higher milk prices in the fall of 2010 when the grass is gone and there is no forage to keep the cows in production over the winter. While there may be a lot of cheap ground beef on the market when those cows are sent to slaughter, milk prices will soar and the government is going to have a tough time dealing with that as the USDA has already failed to address the depressed milk prices verses the high cost of production brought on by $70 per barrel oil.

There was an interesting article on 9 Oct 2009 by Ed Wallace regarding oil prices. Speculators are what’s keeping prices up. He says according to the data oil usage in the US actually peaked in 2005 and currently is 2 million barrels a day below that level. In addition, oil reserves are currently at a 25 year high. There are literally tankers out there with no place to drop their oil. When oil hit $147 a barrel last year there wasn’t a single gas station anywhere on the planet that couldn’t sell you all the gasoline you wanted. Where is the supply and demand in that? Currently we are told that the price is going up because of the dollar. Yet the dollar lost 15% of it’s value while oil went up 231% since last December. Worse still, Ed Wallace believes that many of the banks have used the cheap money that got from the TARP funds for oil speculation rather than for making loans. Why are speculators allowed in the oil market at all? Something that has this much impact on our economy should be based on the demand of end users not banks and institutions that have so much money in the oil market that they effect the price for their own gains with no intention of ever taking delivery of the contract.

OPEC appears to concur on the danger posed by permanent demand destruction:

According to the Financial Times today, the cartel on Tuesday said high prices and the economic crisis had triggered a shortfall in demand among members of the Organisation for Economic Co-operation and Development, the rich countries’ club.

“The crisis appears to have induced a permanent loss in oil demand in OECD and slower rate of growth in non-OECD, due to policy measures and changes in consumer behaviour,” the cartel’s economists told ministers in a presentation.

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John joined Reuters in 2008 as one of its first financial columnists, specialising in commodities and energy. While his main focus is on oil markets, he has written broadly on the emergence of commodities as an asset class, regulatory issues and macroeconomic themes. Before joining Reuters, John spent seven years as a senior analyst for Sempra Commodities (now part of JP Morgan) covering base metals and crude oil. Previously, he worked as an analyst on world trade, banking and financial regulation for consultancy Oxford Analytica.